Superjudge Richard Posner has a new book out on the financial crisis, and here's an article in the WSJ that serves as something of a précis of the whole project. Posner tries to finesse the questions of who to "blame" for the crisis and who's "responsible." I'm not sure that's an important distinction, and I don't disagree with his understanding of the mechanics of the collapse, but I thought this was kind of weird:
The conventional wisdom is that very smart bankers misunderstood their own interests. In a capitalist system, if you can't trust self-interest, what can you trust? Judge Posner instead reminds us that shareholders would have punished individual banks that failed to take advantage of low interest rates and seemingly safe, mortgage-backed securities. Likewise, consumers acted rationally over the years to accept offers of mortgages they couldn't afford, given the low risk of a burst bubble.
"At no stage need irrationality be posited to explain what happened," Judge Posner writes. Instead, this was a case of "intelligent businessmen rationally responding to their environment yet by doing so creating the preconditions for a terrible crash." He chiefly blames the Federal Reserve, for "cheap credit."
But long-term interests are interests, too, and financial-sector players were set to ignore these despite some prominent people warning of the potential for a crash. The mass deployment of low capital cushions, historically high leverage, and a belief that there is no such thing as a bear market all seem somewhat irrational. When you interview people who worked at mortgage lenders, or investment bankers who bought MSBs, many will admit that they knew the loans they were making were fraudulent, or that they didn't follow any standard underwriting procedures to check the quality of loans they were investing in. A mortgage-lending supervisor at WaMu was on cocaine during the workday, for goodness sake. There were definitely fundamentally irrational practices going on. Meanwhile, this guy just sat on his cash through the crisis and now seems poised to make it really big -- that's rational.
At the end of the day, Posner is right that strong regulations are required to fence in capitalism's excesses. But it would behoove him to stop clinging to the idea that neoclassical ideas about the rationality of economic actors are as true in the real world as they are in economic models. For starters, getting rid of that assumption will likely lead to more effective regulatory policy.
-- Tim Fernholz
